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Memo to: Oaktree Clients From: Howard Marks Re: The Lessons of Oil I want to provide a memo on this topic before I

–

and hopefully many of my readers

–

head out for year-end holidays

. I’ll be writing not

with regard to the right price for oil

–

about which I certainly have no unique insight

–

but rather, as indicated by the title, about what we can learn from recent experience.

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Despite my protestations that

I don’t know

any more than others about future macro events

–

and thus that my opinions on the macro are unlikely to help anyone achieve above average performance

–

people insist on asking me about the future. Over the last eighteen months (since

Ben Bernanke’s initial mention that we were likely to see

some

“tapering” of bond buying), most

of the macro questions

I’ve gotten

have been about whether the Fed would move to increase interest rates, and particularly when. These are the questions that have been

on everyone’s mind.

Since mid-2013, the near-unanimous consensus (with credit to

DoubleLine’s

Jeffrey Gundlach for vocally departing from it) has been that rates would rise. And, of course, the yield on the 10-year Treasury has fallen from roughly 3% at that time to 2.2% today. This year many investing institutions are underperforming the passive benchmarks and attributing part of the shortfall to the fact that their fixed income holdings have been too short in duration to allow them to benefit from the decline of interest rates.

While this has nothing to do with oil, I mention it to provide a reminder

that what “everyone knows” is usually unhelpful at best and wrong at worst

.

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Not only did the investing herd have the outlook for rates wrong, but it was uniformly inquiring about the wrong thing

. In short, while everyone was asking whether the rate rise would begin in December 2014 or April 2015 (or might it be June?)

–

in response to which I consistently asked why the answer matters and how it might alter investment decisions

–

few people I know were talking about whether the price of oil was in for a significant change. Back in 2007, in

It’s All Good

, I provided a brief list of some possibilities for which I thought

stock prices weren’t giving enough allowance. I

included

“$100 oil” (since

a barrel was selling in the $70s

at the time) and ended with “the things I haven’t thought of.” I suggested that it’s

usually that last category

–

the thing

s that haven’t been considered

–

we should worry about most.

Asset prices are often set to allow for

the risks people are aware of. It’s the ones they haven’t thought of that can knock the market for a loop.

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In my book

The Most Important Thing

, I mentioned

something I call “the failure of imagination.”

I defined

it as “either being unable to conceive of the full range of possible outcomes or not understanding the consequences of the more extreme occurrences.”

Both aspects of the definition apply here. The usual starting point for forecasting something is its current level. Most forecasts extrapolate, perhaps making modest adjustments up or down. In other words, most forecasting is done incrementally, and few predictors contemplate order-of-magnitude changes. Thus I imagine that with Brent crude around $110 six months ago, the bulls were probably predicting $115 or $120 and the bears $105 or $100.

Forecasters usually stick too closely to the current level, and on

those rare occasions when they call for change, they often underestimate the potential magnitude

. Very few people predicted oil would decline significantly, and fewer still mentioned the possibility that we would see $60 within six months. For several decades, Byron Wien of Blackstone (and formerly of Morgan Stanley, where he authored widely read strategy pieces) has organized summer lunches in the Hamptons for

“serious,”

prominent investors. At the conclusion of the 2014 series in August, he reported as follows with regard to the consensus of the participants: Most believed that the price of oil would remain around present levels. Several trillion dollars have been invested in drilling over the last few years and yet production is flat because Nigeria, Iraq and Libya are producing less. The U.S. and Europe are reducing consumption, but that is being more than offset by increasing demand from the developing world, particularly China. Five years from now the price of Brent is likely to be closer to $120 because of emerging market demand.

I don’t mean to pick on B

yron or his luncheon guests. In fact, I think the sentiments he reported were highly representative of most

investors’ thinking at the time.

As a side note, it’s interesting to observe that growth in China

already was widely understood to be slowing, but perhaps that recognition never made its way into the views on oil of those present

at Byron’s lunches

.

This is an example of how hard it can be to appropriately factor all of the relevant considerations into complex real-world analysis

.

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Turning to the second aspect of “the failure of imagination” and going

beyond the inability of most people to imagine extreme outcomes, the current situation with oil also illustrates how difficult it is to understand the full range of potential ramifications.

Most people easily grasp the immediate impact of developments, but few understand

the “second

-

order”

consequences . . . as well as the third and fourth

. When these latter factors come to be

reflected in asset prices, this is often referred to as “contagion.”

Everyone knew in 2007 that the sub-prime crisis would affect mortgage-backed securities and homebuilders, but it took until 2008 for them to worry equally about banks and the rest of the economy. The following list is designed to illustrate the wide range of possible implications of an oil price decline, both direct consequences and their ramifications:

o

Lower prices mean reduced revenue for oil-producing nations such as Saudi Arabia, Russia and Brunei, causing GDP to contract and budget deficits to rise.

o

The

re’s a drop in the

amounts sent abroad to purchase oil by oil-importing nations like the U.S., China, Japan and the United Kingdom.

o

Earnings decline at oil exploration and production companies but rise for airlines whose fuel costs decline.

o

Investment in oil drilling declines, causing the earnings of oil services companies to shrink, along with employment in the industry.

o

Consumers have more money to spend on things other than energy, benefitting consumer goods companies and retailers.

o

Cheaper gasoline causes driving to increase, bringing gains for the lodging and restaurant industries.

o

With the cost of driving lower, people buy bigger cars

–

perhaps sooner than they otherwise would have

–

benefitting the auto companies. They also keep buying gasoline- powered cars, slowing the trend toward alternatives, to the benefit of the oil industry.

o

Likewise, increased travel stimulates airlines to order more planes

–

a plus for the aerospace companies

–

but at the same time the incentives decline to replace older planes with fuel-efficient ones. (This is a good example of the analytical challenge: is the net impact on airplane orders positive or negative?)

o

By causing the demand for oil services to decline, reduced drilling leads the service companies to bid lower for business. This improves the economics of drilling and thus helps the oil companies.

o

Ultimately, if things get bad enough for oil companies and oil service companies, banks and other lenders can be affected by their holdings of bad loans.

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Further

, it’s hard for most people

to understand the self-correcting aspects of economic events

.

o

A decline in the price of gasoline induces people to drive more, increasing the demand for oil.

o

A decline in the price of oil negatively impacts the economics of drilling, reducing additions to supply.

o

A decline in the price of oil causes producers to cut production and leave oil in the ground to be sold later at higher prices. In all these ways, lower prices either increase the demand for oil or reduce the supply, causing the price of oil to rise (all else being equal). In other words, lower oil prices

–

in and of themselves

–

eventually make for higher oil prices.

This illustrates the dynamic nature of economics

.

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Finally, in addition to the logical but often hard-to-anticipate second-order consequences or knock-on effects, negative developments often morph in illogical ways. Thus, in response to cascading oil prices

, “I’m going to sell out of emerging markets that rely on oil exports” can turn into “I’m going to sell out of all emerging markets,” even oil importers that are aided by cheaper

oil. In part the emotional reaction to negative developments is the product of surprise and disillusionment.

Part of this may stem from investors’ inability to understand the “fault lines”

that run through their portfolios. Investors knew changes in oil prices would affect oil companies, oil services companies, airlines and autos. But they may not have anticipated the effects on currencies, emerging markets and below-investment grade credit broadly. Among other things, they rarely understand that capital withdrawals and the resulting need for liquidity can lead to urgent selling of assets that are completely unrelated to oil.

People often fail to perceive that these fault lines exist, and that contagion can reach as far as it does. And then, when that happens, investors turn out to be unprepared, both intellectually and emotionally. A grain of truth underlies most big up and down moves in asset prices.

Not just

“oil’s in oversupply”

today,

but also “the Internet will change the world” and “mortgage debt

has historically been safe

.”

Psychology and herd behavior make prices move too far in response to those underlying grains of truth, causing bubbles and crashes, but also leading to opportunities to make great sales of overpriced assets on the rise and bargain purchases in the subsequent fall.

If you

think markets are logical and investors are objective and unemotional, you’re in for a

lot of surprises.

In tough times, investors often fail to apply discipline and discernment;